You're Being Taken to the Cleaners

If you're not outraged, you haven't been paying attention.

Slightly more than a week ago, we were told that the entire financial market was about to implode because Bear Stearns (NYSE: BSC) was unable to meet a margin call. As a result of that so-called crisis, The Federal Reserve arranged and agreed to subsidize a bailout of Bear Stearns by JPMorgan Chase (NYSE JPM). If that weren't bad enough, as part of the crisis response, the Fed also voted itself special emergency powers to lend directly to certain securities dealers as well as banks.

What a difference a week makes. Apparently, things weren't as bad as we were led to believe.

After all, the buyout price has just quintupled -- to $10 a share from $2, to appease Bear Stearns shareholders who felt they were getting a raw deal, despite being heavily subsidized.

Where's the fire?If there's really five times as much value in Bear Stearns than we were led to believe just a week ago, then why:

Is the Fed still guaranteeing $29 billion of the $30 billion it kicked in to seal the deal?

Hasn't the Fed closed the new window that lets it lend to securities brokers?

It would seem that either the Fed panicked again and doesn't want to admit its newest misstep, or that it's more interested in providing welfare payments to billionaires than doing its real job. Either way, as things stand now, you and I are subsidizing the risks that JPMorgan and Bear Stearns are taking, and their shareholders and managers are receiving the rewards.

Nice work if you can get itHere's how ugly this raw deal looks. The special window the Fed has opened lets prime brokers borrow at 25 basis points above the current Federal Funds rate. Since the Federal Funds rate is now at 2.25%, they're able to borrow money at 2.5%. In this market, it doesn't take a genius to see how they can essentially print money with loans that cheap. They simply need to borrow at 2.5% and buy stocks with higher yields. Those with politically privileged access to federal cash can clean up on a fairly generous yield spread, even with well-known firms such as these:

Company

Current
Yield

Spread
Over Fed

Home Depot (NYSE: HD)

3.20%

0.70%

General Electric (NYSE: GE)

3.30%

0.80%

Verizon (NYSE: VZ)

4.80%

2.30%

Pfizer (NYSE: PFE)

6.20%

3.70%

Bank of America (NYSE: BAC)

6.10%

3.60%

Sure, the recipients of this largesse will have you believe that it's only being used to shore up their ailing balance sheets. In reality, money is fungible. As long as they own one single solitary share of stock while touching this virtually free federal cash, it's the equivalent of borrowing that money to make the investment.

Don't forget -- the market has rallied almost constantly since the new window opened. It's very unlikely that's a coincidence.

2+2 = Really uglyTaken as individual actions, the federal bailout of Bear Stearns and the direct access to federal cash would be bad enough. Perhaps the most pernicious part of the whole ordeal is what happens when you put the two together. The cheap money lets the prime brokers clean up, with virtually no effort or real risk. The bailout signals that if, for some reason, the new leveraged investing schemes run into the same troubles that Bear Stearns' did, the Fed will be there to pick up the pieces.

In other words, just like with JPMorgan and Bear Stearns, you'll pay the bill if their plans fail, but they'll reap the rewards if they succeed.

Enough is enough. Either drop the subsidy to scuttle the deal, or close the emergency window, or both. But for heaven's sake, stop destroying the entire financial system just to help a few billionaires get richer at taxpayer expense.

Author

Chuck Saletta has been a regular Fool contributor since 2004. His investing style has been inspired by Benjamin Graham's Value Investing strategy. Chuck also can be found on the "Inside Value" discussion boards as a Home Fool.